I spend most of my time digging into Wall Street, hedge funds and private equity firms, looking for both the good and the bad. I also focus on the intersection of business and the law. I have worked at Forbes since 2000.

10/17/2011 @ 7:04AM40,031 views

Wall Street's New Nightmare: The Next Wave Of Mortgage-Backed Securities Claims

Her $8.5 billion Bank of America settlement over bad mortgage deals was just the beginning. Now, backed by bond giants Pimco and BlackRock, Texas lawyer Kathy Patrick is gearing up for a new legal assault on the financial industry.

Kathy Patrick: The woman Wall Street fears most.

This article appears in the November 7 edition of Forbes magazine.

The biggest private legal settlement in the history of Wall Street was a few sentences away from death. In early June a ­little-known Texas lawyer named Kathy Patrick was putting the final touches on her carefully crafted $8.5 billion deal with Bank of America over so-called mortgage put-backs, when she got a last-minute demand from the other side. Sitting in her Houston office, Patrick learned that BofA wanted her clients—a clutch of the world’s most important investment firms, including BlackRock and Pimco—to promise they would not go after the bank with separate claims over the same mortgage pools.

No way, she answered. As far as Patrick was concerned, she had made clear such a release was not on the table. Some of her clients had already filed securities claims against Bank of America. “It’s not every day that you write a letter to someone,” the 51-year-old says, “and tell them to take their $8.5 billion and shove it.”

Bank of America’s gambit turned out to be a bluff. On June 29 the nation’s largest bank announced it had struck the second-biggest legal settlement in American history, trailing only the 1998 tobacco master settlement. Three weeks later BofA reported an $8.8 billion quarterly loss, the start of a long and difficult summer in Charlotte.

Rather than celebrate a career-capping victory, Patrick viewed it a different way: round one. And that has Wall Street terrified right now.

Publicly the financial industry and the White House are dancing around a potential $20 billion settlement being forced on the nation’s biggest banks by state attorneys general over improper foreclosure practices. Quietly and without fanfare, Patrick and her 23 bondholding giants—one of the most powerful investor groups ever assembled for litigation—are gearing up for something equally big: a painful new reckoning for the mortgage-lending debacle, with most of Wall Street’s big banks in her crosshairs. “This group did not come together just to deal with Bank of America. They came together because they wanted a comprehensive industrywide strategy and an industrywide solution,” Patrick tells FORBES. “They started with Bank of America because they thought they could achieve a template that they could extend to other institutions.”

The new sheriff of Wall Street, a private-sector Eliot Spitzer described by a peer as “the toughest lawyer you will see,” works out of an unassuming 33-lawyer Houston firm. She teaches Bible study on Sundays and sings in her church band, while raising two teenage boys with her husband. And backed by the biggest investors in bum mortgage-backed securities, she has a mandate to lay siege. “Who else has ever gotten $8.5 billion out of anyone? Go find a settlement where anybody in history got $8.5 billion in a private settlement,” says Jason Kravitt, a lawyer who represented Bank of New York Mellon in the Bank of America settlement talks. “She manages to be sufficiently aggressive and constructive with the right combination of threats and creativity.”

The daughter of a U.S. Army lieutenant colonel, Patrick grew up in El Paso, Tex. and has mostly been rooted in Texas since. She attended Harvard Law and clerked for the great civil rights judge John Robert Brown. She was the ninth lawyer hired at Gibbs & Bruns, where she has worked for 25 years. Part of what makes her formidable is her comfort on either side of the table: She made her national mark on defense, representing Enron’s outside directors after the company collapsed, and then quickly pirouetted to offense, securing a $1.7 billion settlement for Huntsman Corp. in a dispute with Deutsche Bank and Credit Suisse.

Patrick refuses to say which banks her investment group is now going after but admits she picked a fight with the biggest kid on the block—Bank of America and its junk-mortgage-riddled Countrywide Financial unit—to send a message to the rest of Wall Street. Her natural targets—other big banks with units that underwrote large amounts of subprime, Alt-A, or option ARM mortgage-backed securities during the housing boom—include JPMorgan Chase, Royal Bank of Scotland, Wells Fargo, Deutsche Bank, Credit ­Suisse, Morgan Stanley, Citigroup, Goldman Sachs and Ally Financial. None of these banks would comment for the record for this story (nor would BofA). But all issued fewer MBS to investors than Countrywide and might have had better underwriting practices, making them less vulnerable to legal attack.

That hasn’t stopped the panic. When Patrick’s attack on Bank of America ­surfaced a year ago, the stock price dropped 4%, and the Securities & Exchange Commission posted a letter reminding the rest of the industry that it needs to disclose risks associated with such claims. (So far none has reserved specifically for this sort of thing.)

Patrick’s war on Wall Street came to her. During the real estate boom Countrywide created hundreds of securitization trusts, selling certificates backed by residential mortgage loans. In these deals Countrywide made representations and warranties about things like loan quality and committed to repurchase the loans if those representations turned out to be bogus. But there was a catch: Investors needed at least 25% of so-called voting rights in a trust to declare a default and possibly compel the administrating trustee to enforce repurchases. A lawyer in Dallas, Talcott Franklin, had created a clearing­house, hoping that enough of these MBS bondholders might band together to meet these thresholds.

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Nathan, congratulations on the article. Meanders, fostered by the obscure “hunger” excessive profit, may actually lead to fear of Wall Street, while having the reliability of business practiced it. This financial world, yet a world reference, requires caution as well as deep knowledge of their environment. You were right!